This Stock Could Be the Dow's Biggest Gainer in 2012

By: David Sterman

Posted: 11/8/2011 9:00:00 AM

Referenced Stocks: DELL;EPS;HPQ;IBM

Focusing on "
turnaround
" stocks was a favorite angle for investors in the 1990s. Many
companies had been run poorly, but new management could easily
unlock value by focusing on a deep restructuring. The key was to
find businesses that still possessed sizable
market share
, brought in new leadership and most importantly, were already
cheap based on current
cash flow
, let alone what future cash flow growth might entail.

This is the recipe in place for
Hewlett-Packard (NYSE:
HPQ
)
today, which only a few decades ago was considered to be one of the
premier technology firms in
Silicon Valley
. New
CEO
Meg Whitman has her work cut out for her, but she inherits a
business that is already a cash-producing machine (
free cash flow
has averaged $8.5 billion during the past three years). And trading
at just six times projected 2012 profits, it's clear investors
aren't holding her to a very high set of expectations. Look for
Whitman to lay out plans to revitalize the company in coming
months. Far-sighted investors need to pay attention.

Fixable, not broken
From Wang to Digital Equipment to Novell, the high-tech sector is
filled with examples of companies that lost their luster and faded
into oblivion. These were broken business models that were
ultimately sold off for a fraction of their peak value. Yet HP
isn't broken and there is a clear fix in place for its myriad
businesses. Trouble is, previous management moves have failed to
really tackle any core challenges the company faced. Former CEO
Mark Hurd was more concerned with cost-cutting and acquisitions,
while virtually ignoring internal development. Cost-cutting helped
boost
earnings per share (
EPS
)
steadily in the last half of the past decade (from $0.82 per share
in 2005 to $3.25 in 2008), but underinvestment in the business
started to create an opening for rivals to take market share.

Let's look at
IBM (NYSE:
IBM
)
as an example. While both firms focus on large enterprise contracts
that entail management of all aspects of a client's technology
base, IBM was investing heavily in software, noting that this
value-added segment can bring more robust
profit
margins than simple hardware configurations. As a result, IBM
generates 20% operating margins, while HP's enterprise unit
generates 15% operating margins. A recent move to acquire Autonomy
Corp. for $10 billion will boost HP's software efforts -- though HP
vastly overpaid for it -- yet Whitman will acknowledge that HP
needs to invest even more in software in 2012.

In the computer segment, HP was lauded for overtaking
Dell (Nasdaq:
DELL
)
as the world's top seller in 2006, but a lack of investments led
the company to virtually miss the ongoing tablet-computer
revolution. Still, HP's commanding size in the PC business gives it
significant buying power in terms of components, which helps HP
generate $2 billion in free cash flow from this business. A
just-announced decision to retain this division (and likely step up
investments in 2012) is a wise one, as computer sales are so
closely intertwined with HP's other divisions such as printers and
services.

The printer division, by the way, is a crown jewel, with 40% global
market share (as much as Canon and Epson's combined share). The
division's 16% operating margins (and $4 billion in annual
operating cash flow) are the simple results of ongoing investments
in printing technology. This is a lesson likely not lost on Whitman
as she draws up plans to revive other parts of the business.

Analysts at Aurgia Securities have analyzed each of HP's divisions,
assessing a comparable value for each against a set of peers. On a
sum-of-the parts basis, they say
shares
could trade up to $47 from a current $27. Yet few will buy HP stock
on this rationale. Instead, they want to see how Whitman can tinker
with the business to restore HP's competitive positioning.

So how will this play out? A bit of counter-intuitive logic is
necessary. Myopic investors often look to dump the stock of a
company when it announces plans to step-up spending (reducing
EPS
guidance in the process). Yet HP is an exception. Let's assume the
current 2012 EPS forecast of $4.70 a share needs to be slashed to
$4 as spending rises. Well, the stock is still cheap, and would
trade for just seven times that lowered figure. More important, the
spending signals HP won't just sit on its hands anymore. It plans
to remain relevant -- and thrive -- well into the future. Doubts
about the future are what this cheap stock price is really telling
you.

This lowered guidance is likely to come this winter as the new CEO
"resets expectations." This is what all CEOs do, and it is widely
expected from HP. To be sure, most investors will take a
wait-and-see attitude to see how Whitman's strategy will play out.
So shares of HP are unlikely to move back to the $40 mark very
quickly. But over the course of 2012, there's no reason this stock
can't move back to the mid-$40s (simply based on that
sum-of-the-parts analysis that Auriga's analysts suggest).

Risks to Consider:
Tech spending by corporations has held up fairly well in 2011
and is expected to remain robust. Any pullback in tech spending
would keep HP from reaching new profit
margin
goals that are laid as out as any part of a business
transformation.

Action to Take -->
This is an absurdly cheap stock that is subject to very low
expectations. Yet a considerable amount of strengths remain, and
Whitman's turnaround task is not as steep as the lagging share
price implies. Even if the plan takes longer to realize, shares are
so cheap that they likely possess considerable downside protection.
That 74% gain to reach Aurgia's
price target
should look tempting, yet keep in mind that this is only a play for
the patient investor, because it's likely to be "three steps
forward and two steps back" as HP slowly pivots back into investor
favor.

-- David Sterman

Disclosure: Neither David Sterman nor StreetAuthority, LLC hold
positions in any securities mentioned in this article.